How Savvy Colorado Property Investors Utilize Deferred Tax Transactions
Current and prospective investors know that the market is always in flux and what may have been a good investment then, may not be now. So how can an investor keep their investment properties profitable and take advantage of a changing market? The answer lies in 26 U.S.C. § 1031 of the IRS code, referred to as a 1031 exchange.
In short, a 1031 exchange allows a taxpayer to swap an investment property for another “like-kind” property without having to pay capital gains tax. A “like-kind” property is defined as property that is of the same nature, character or class. Additionally, there is no limit to how many 1031 exchanges a taxpayer can make. So how can someone take advantage of this IRS approved tax deferment? To start, it depends on the investor’s circumstance and investment goal. Depending on those things, there are four types of 1031 exchanges to choose from.
1. Simultaneous Exchange
This is a direct exchange of “like-kind” property between two parties. Under this type, most transactions where a property is relinquished and the replacement property is closed on in the same day. However, this is the least used exchanged, as it can be difficult to find a like-minded investor who also happens to have a similar property.
2. Delayed Exchange
This type allows for an investor to sell a property and find a replacement property within a certain amount of time. As this gives the investor more time between the sale and replacement process, it is the most popular 1031 exchange.
3. Reverse Exchange
This is for an investor who has found a replacement property before they were able to sell the current property. To close on the replacement property, the seller must give the title of either the relinquished or replacement property to a LLC (limited liability company), who will “park” the title until the other property is sold. This must be done, as an investor is not allowed to hold both titles simultaneously. Once the other property is sold, then the LLC will transfer the title of the replacement property.
4. Improvement Exchange
A requirement for a 1031 exchange is that one property must be replaced by a property of equal or higher value. This type of exchange overcomes this rule by allowing an investor to buy a less valuable property, so long as the remaining funds from the sale of the original property are used to build/improve the replacement property. This way, no profit from the sale of the original property can be taxed, as it is instead funneled into the replacement property.
Cardinal rules to follow:
Must be a “like-kind” property. This means that you cannot sell a rental property for construction equipment. Instead, the properties must be of the same “nature” or “character” – such as apartment complexes, restaurants, vacation rentals or commercial office buildings are all alike. Further, the exchange doesn’t have to be a 1:1 ratio, but instead could be multiple properties for a single, larger property or vice versa.
All properties must be located in the U.S. As a 1031 exchange is an IRS rule, it only impacts properties within federal scope. Thus this rules out international properties, as these exchanges would involve the jurisdiction of other countries.
Personal property doesn’t count. A 1031 exchange can only involve a business or investment property. So primary residences cannot be exchanged, if say, one were to move from one state to another.
Equal or greater value. Exchanges can only occur on properties of equal or greater value to the original property. If an investor chooses to buy a property of lesser value, then they must either conduct an improvement exchange or pay taxes on the differential amount.
The 45 and 180-day window. To qualify for a 1031 exchange, an investor has to abide by two deadlines: A seller has 45 days after closing on the sale of the first property to locate another replacement property; and, a seller has 180 days (or six months) to purchase a replacement property.
For a savvy investor, the 1031 exchange allows investment flexibility, while saving thousands of dollars in taxes. That is if such a person can abide by various IRS rules and understand the particulars of real estate investing, market cycles, and growth opportunities.
Due to the complex process of 1031’s, coupled with the fact that even a small mistake can jeopardize tax deferment, even career investors tend to seek help. For those who would like more information on 1031 exchanges, need advice on a transaction or need a legal review of paperwork, please contact our real estate attorneys at Robinson & Henry for an assessment.